Talking Litigation Funding; Suing the SEC Over Market Rules; Small but `Sophisticated' Investors; Republicans Go After China
Capitol Account: Free Weekly Version
A lot going on this week, across the spectrum of financial regulation policy. The now Republican-led House Financial Services Committee came out of the gate with hearings on China’s economic threats and helping small businesses get more funding. One target was the SEC’s accredited investor standard, which says only people with a $1 million net worth can participate in private market deals (think, getting in early on the next hot start-up). We covered the hearings, but also noticed that the Republican threats to immediately haul up SEC Chair Gary Gensler for some oversight haven’t yet come to fruition. Maybe next month? We also wrote about a big trade group’s early opposition effort to Gensler’s stock trading rules. No surprise, it’s a lawsuit in waiting. And for our Friday Q and A, we talked to the head of a trade association for a growing industry that is now getting scrutiny in Washington: lawsuit financing.
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Friday Q and A: Here in Washington, it seems like there is an association for pretty much everything in finance – banks, hedge funds, fintech startups, crypto firms, you name it. But every now and then, we come across an organization that has largely escaped our notice, even though it has a pretty interesting remit. That’s certainly true of the International Legal Finance Association, a group that represents firms that invest in lawsuits. It’s been increasing its efforts in Washington as it gears up for a potentially big battle with the much larger U.S. Chamber of Commerce.
Litigation funding is a growing area (a 2021 report found there are some 47 active commercial litigation funders who have a combined $12.4 billion in assets under management) that has started drawing scrutiny from lawmakers. The Chamber significantly elevated the issue late last year by releasing a paper that called it a “secretive industry” that could have “harmful repercussions for consumers, American businesses and U.S. national security interests.”
To find out what’s going on – and to figure out what litigation finance really is – we sat down this week with Gary Barnett, who has been ILFA’s executive director for about a year and a half. He’s a former Brooklyn prosecutor who came to Washington to work for then-Sen. Jeff Flake. Barnett joined the Justice Department during the Trump administration where he was a staffer for Attorney Generals Jeff Sessions and William Barr. Read on for our (lightly edited and condensed) discussion about this investment strategy, the Chamber’s criticisms and how a conservative lawyer ended up in this unusual business.
Capitol Account: With all the trade groups in D.C., why is there a need for one specifically on litigation finance?
Gary Barnett: The industry was maturing to a point where the members wanted to partner together, to have an organization that would advocate and educate on its behalf. But in addition to that, some of the opponents of the industry were growing louder.
CA: You’re a Republican, and they don’t often like lawsuits. How did you decide to work in this area?
GB: For me, I see the benefit of the legal system working. I see the benefit of those that have been harmed being able to pursue just compensation. That’s been my overarching perspective. I think legal finance fits perfectly in there. There are those who try to mischaracterize what the industry is doing. We bring meritorious cases because the business model requires it. If you're funding not meritorious cases, you're not going to be in business for very long.
CA: How does this work? What is the money used for?
GB: It depends on what type of case, what kind of investment you're talking about. In some instances, it's to pay legal expenses and experts. But there’s also monetization.
CA: The funder essentially pays the award ahead of time?
GB: If there's a judgment in a particular matter and you have to go through appeal, you're able to actually monetize a portion of that judgment...From a business perspective, it's beneficial to be able to get the capital back into the company.
CA: What kind of cut do the funders take when they win a case or get a settlement? Is there a standard percentage?
GB: They're all very bespoke. The legal issues in every case are different, and the legal risks in every case are different. A lot of it just depends on the funder's assessment.
CA: And what the company is willing to pay?
GB: Correct. It's an arm's length deal.
CA: What kind of firms does ILFA represent?
GB: We have 19 members currently. Some are purely commercial legal finance providers, their business is only legal finance…We also have some multi-strategy funds that have a component that focuses on legal finance specifically…Some of our members are also publicly traded companies.
CA: Who invests in this?
GB: The investors are quite diverse. There’s pension funds, there are multi-strategy funds. Anyone who is looking to diversify their portfolio.
CA: Well, if this exists as an investment option, we assume people probably can make money off it.
GB: Our members have shown themselves to be able to provide a good return. It’s a non-correlated asset, as well. There are investors that see value in that, especially during more turbulent economic times.
CA: When people hear about funding lawsuits, many probably picture ambulance chasing plaintiff’s lawyers and personal injury cases. Do your members get involved in that?
GB: ILFA represents the commercial legal finance industry. Our members primarily are investing in large, business-to-business [matters] – multi-million dollar commercial disputes that involve contracts, antitrust, arbitration, intellectual property.
CA: You mentioned your opponents in Washington. That seems to be mainly the Chamber. What did you make of the study it released that argued hostile foreign governments could harm U.S. national security by funneling money into lawsuits that target strategically important industries. It also called for more disclosure of funding agreements and more federal oversight.
GB: That whole paper that they put out is absurd. And it is all speculation. They have not identified a single instance where any of the concerns that they raised actually exist…The investors are not deciding which cases will be invested in. The investors don't have an ability to control any aspect of the litigation.
CA: Why do you think the Chamber wants to crush litigation finance?
GB: I think this is something that a few of their donors see as a threat – [having competitors] on the other side of litigation with the resources to defend themselves, or to prosecute a claim. Legal finance presents the opportunity to level the playing field…(Friday)
Litigation Prep: As some traders like to joke, it’s not a question of who will sue the SEC over its market structure revamp, it’s a question of who makes it to the courthouse first. There may even be a line. In reality, top lawyers are already being retained and legal strategies are being plotted. Now, some of the behind-the-scenes maneuvering is starting to emerge in comment letters to the agency, as well as in other moves by the heavyweight trade associations Wall Street relies on to make its arguments in Washington (especially via lawsuits).
One blueprint for how brokerages and trading firms may challenge the SEC came out in a letter that the Securities Industry and Financial Markets Association fired off to the agency Wednesday. In it, the trade group ostensibly asked for more time to respond to the commission’s plan, which was proposed in mid-December. That’s a pretty run-of-the-mill request (which the commission generally ignores.)
But more importantly, the letter also revealed that the association filed a Freedom of Information Act request for all the data the SEC used to craft its overhaul. The broker lobby group buttressed that demand by highlighting several legal precedents where federal agencies were required to turn over data used to develop policies. Should the SEC fail to provide the records, Sifma warned, it would likely be violating the law: “[C]ourts have long recognized there to be a compelling public interest and requirement under the Administrative Procedure Act that a federal agency, such as the commission, identify and make available technical studies and data used in reaching the decisions to propose particular rules.”
The legalistic letter heralds what is expected to be one of the industry’s main lines of attack in any court cases. Many of the regulator’s opponents, including retail brokers and market makers that Sifma represents, don’t believe the SEC has sufficient data to justify what would be a breathtaking overhaul of the stock market. And by filing the public records request, Sifma essentially gets a two-for-one deal. Those documents would, of course, be valuable for identifying potential shortfalls in the agency’s review of the costs and benefits of its rule. However, if the SEC rejects the FOIA petition, Sifma can sue over that as well.
Sifma hasn’t been much of a vocal player thus far in the market structure debate (though it did hold a roundtable meeting that we wrote about last year). But its members include many firms that have been among the most unhappy with the SEC plan, including Charles Schwab, Robinhood, Citadel Securities and Virtu Financial.
Nevertheless, the group dismissed the notion that its letter and records request were an early sign that it is preparing for a legal challenge. “We need the data to complete an independent economic analysis as part of the comment letter process, which is something that the SEC highly encourages commenters to do,” said spokeswoman Katrina Cavalli. “Nothing more to it.”
The SEC didn’t respond to a request for comment.
The agency’s effort is tackling numerous complex and overlapping issues. It consists of four separate rule proposals: a requirement that many retail orders be sent to auctions; new disclosure obligations for brokers that detail how well they handle customer transactions; a federal standard that defines the “best execution” of a trade; and revisions to exchange fees and share price increments. Gensler says the changes will boost competition and lower trading costs, especially for smaller investors, by clamping down on the stock market’s middlemen … (Thursday)
Allowing More Investors in the Private Markets: As the new leaders of the House Financial Services Committee, Republicans are wasting little time showcasing their priorities – and looking for ways to take on SEC Chair Gensler. On Wednesday, Ann Wagner used her first hearing as chairwoman of the capital markets subcommittee to demand an overhaul of the agency’s 40-year-old standard that requires investors to have a $1 million net worth before they are deemed “sophisticated” enough to participate in private deals. Changes to the rule are on the SEC’s agenda as well. But Wagner and her colleagues want to lower it, while Gensler and his Democratic commissioners favor beefing it up.
The so-called accredited investor issue is a smart first step for Wagner because it goes to the heart of one of Republicans’ favorite topics – capital formation and how regulation hinders it. It also allows the lawmakers to bring up a host of inter-connected complaints: the dearth of IPOs, the troubles that entrepreneurs face funding their companies and the inability of the middle-class and lower-income investors to get in on the next hot start-up. As Wagner noted in her opening remarks: “Expanding opportunities for all investors and entrepreneurs is not just a moral imperative, but it is also essential for the growth and prosperity of our economy.”
Wagner cleverly billed the gathering as being about “sophistication or discrimination,” and she brought in a slate of mostly minority executives who favor scaling back the SEC’s accredited investor rule. The witnesses included Eli Velasquez, the founder of the Investors of Color Network; Omi Bell, the founder of Black Girl Ventures; and David Olivencia, CEO of Angeles Investors. Duke Law Professor Gina-Gail Fletcher was alone in opposing a loosening of the stricture. Missing, by the way, were any representatives from major private equity firms and hedge funds that have lobbied over many years for the SEC to relax its standard (and open their funds up to a lot more customers.)
The Republicans generally welcomed the witnesses as true American success stories. “You are the voices and the faces and the stories that many of us on this side of the aisle have been talking about for years – that have been dismissed by those on the other side and certainly by the chair of the SEC,” Bill Huizenga remarked. (The other good zing at Gensler came from French Hill, who said the chair seemed to be too busy turning the agency into the “Securities and Environmental Commission” to focus on capital formation.)
Democrats had to walk a finer line. They agreed, of course, that minority-owned businesses need more access to capital. And they stressed that the SEC’s income standard – issued in 1982 – could use some tweaking. But they were quick to point out that fraud at private companies like FTX and Theranos caused huge losses for “sophisticated” investors.
Subcommittee ranking member Brad Sherman noted that the $1 million net worth requirement likely needs adjusting since it was set during the Reagan administration. (That doesn’t include the value of a home. Individuals with a $200,000 annual income, or $300,000 jointly with their spouse, are also deemed accredited investors by the SEC.) Still, he preached caution. “Private markets are important. They tend to be inherently risky,” Sherman said. “We shouldn’t be lowering standards, but we should be rationalizing standards.”…(Wednesday)
China Economic Threats: If anyone expected sparks to fly at the House Financial Services Committee’s first hearing under its new Chairman Patrick McHenry, they would’ve been mistaken. But since he picked the topic of China (and not, as some of our readers had hoped, SEC Chair Gensler) there was an ample display of bipartisanship over the economic threats that the Asian superpower poses to the U.S. For several hours, Republicans and Democrats on the panel took turns bashing Beijing over its treatment of American companies – and suggesting new regulatory efforts to boost competition. No surprise, there were also questions about why the Biden administration didn’t move faster to shoot down the Chinese spy balloon.
What was very clear from the tenor of the hearing is that tension with China appears to be nearing a tipping point in Washington – and U.S. businesses will have to carefully navigate those politics in the months ahead. While it’s hard to predict whether the mutual hostility will lead to legislative agreements, most agree that the issue is more likely to generate compromise than most others. What follows is a brief overview of issues that cropped up, with a focus on financial regulatory matters.
McHenry’s opening statement: The North Carolina Republican promised that his panel will be taking the lead in forging a response to China’s rise. He signaled that may include passing bills on sanctions, export financing and the international banking system. McHenry also indicated that some of his ideas are de-regulatory, which will likely please corporate executives.
“We need to carefully evaluate if a policy proposal could jeopardize America’s ability to innovate, grow and allocate capital, or if it would cause allies to question our commitment to free people and free markets,” he said.
Waters on debt ceiling: Ranking Democrat Maxine Waters did inject some partisanship into the proceedings by claiming that Republican “brinkmanship” that on the debt ceiling risks destabilizing the U.S. economy in a way that provides a massive gift to China (a point that several other Democrats also made). That said, Waters didn’t get off to a great start because she mistakenly pinned the debt ceiling fight a decade ago (which caused interest rates on Treasury bonds to skyrocket) on Democrats’ intransigence. She later expressed support for having a CFIUS-like review for U.S. investments in Chinese companies.
An oh #$%& moment: Florida Republican Bill Posey had a rough time when he asked the panel of witnesses, mostly lawyers who previously worked at government agencies, for data on China’s emerging economic dominance. First, he sought a figure on the amount of U.S. debt held by the country. No one knew. Then he asked how much U.S. land is owned by China. Again, no response. That prompted Posey to say, “Oh shit.”
Sherman on tariffs: California Democrat Sherman said American companies should have to disclose risks to their businesses if there is a breakdown in U.S. relations with China. He also said the U.S. should start playing hardball with China, but he expressed skepticism that both Congress and the White House would take a tough stance.
“We need to have an automatic, say 20 percent, tariff on all Chinese goods if they retaliate against us for anything we are doing,” Sherman said. “Of course, that would only be necessary if we did anything significant. We probably won’t.”
The lawmaker added that any coercion Beijing exerts over U.S. companies has to be stopped. “One thing that concerns me is the ability of China to control U.S. corporations by handing out access to their market like dog treats to my pet.” …(Tuesday)
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